5 Min Read
* M&A activity increases event risk in high-yield
* Upside capped in both primary and secondary
* Call date guessing games abound
By Robert Smith
LONDON, April 16 (IFR) - The rush for junk bonds is threatening to strip out any upside high-yield investors could get from event risk, just as large scale M&A and IPO activity returns to Europe.
European high-yield bond funds have seen almost US$13bn of retail inflows since the beginning of the year, according to Bank of America Merrill Lynch, and this wall of cash chasing new deals has eroded covenant strength in the primary market to investors' disappointment.
"With M&A picking up you want to keep hold of as much optionality as possible, yet so much optionality is being stripped away in the primary market," said Fraser Lundie, co-head of credit at Hermes Fund Managers.
Private equity firms are making liberal use of portability clauses, which allow bonds to stay in place after a change in company ownership, stripping away the potential upside of a change of control put for investors.
These clauses were once a niche feature that commanded a premium, and as recently as last summer Unilabs was forced to scrap a planned portability clause after investor pushback.
However, portability is now so rife that it has been included in floating rate notes for the first time, despite the fact they barely need it as 101 calls after one year already make them easy to refinance in the event of a buyout.
Belgium-headquartered fast food chain Quick began marketing its recent bond with portability in its senior secured FRN only, but was able to expand the feature to its more junior unsecured FRN when the bonds priced, to the dismay of investors.
"You need a lot of confidence in the business to hold the risks at an unsecured level over to the next owner," said one.
Other tweaks are allowing issuers to repay more and more debt early, capping the price appreciation from a positive credit event such as an IPO.
Equity claws, which allow issuers to repay debt early using proceeds from an equity offering, are being loosened. Market convention used to be a 35% claw at par plus the coupon, but this has weakened.
A 4.15bn-equivalent holdco bond for Altice, for example, which will partly finance the SFR acquisition alongside the 6.04bn-equivalent from Numericable, has a 40% claw at a price of 103, but without the coupon, removing some of the investor upside.
Buying older bonds in the secondary market without these aggressive features can be just as fraught, however, as renewed M&A and IPO activity makes them more likely to be called early.
Most high-yield bonds have embedded call options at set prices and bonds are more likely to be called if M&A activity increases, a dangerous prospect as the bulk of outstanding European junk bonds are now trading at or above their call prices.
"When a well-liked credit only has bonds that are trading to their next call, it's difficult for cash market investors to reflect a conviction view on the issuer in their portfolios," said Peter Aspbury, a high yield portfolio manager at JP Morgan Asset Management.
Both Lundie and Aspbury suggest that using the CDS market can be an effective way around these problems. Selling protection in the CDS market has the added M&A-related upside of orphan risk, in which a contract's underlying securities fall away in a credit event.
The mandates of many high-yield bond managers do not allow them to access the CDS market, however. For these investors, guessing call dates correctly will be a large driver of returns.
"Some bonds are offered at a very negative yield-to-worst, but that isn't always a deterrent," said Aspbury. "Sometimes pushing out your assumption on when the security will be called by a few months can make them quite attractive from a carry perspective."
Europcar's May 2017 sub notes, for example, have a massive 11.5% coupon and no early calls, offering investors great carry. Unusually though, they have a 100% equity claw at 111.5.
The notes are trading around five points above this, and if reports are accurate that the group has appointed Rothschild to launch an IPO, the downside could be significant.
Call date guessing games are rife in PIK toggle notes, as they usually have a 101 call after just one or two years. Miscalculating here can be even more painful, however.
"With PIKs there really is no floor; it'll get taken out at call price or it'll go to nothing," said Lundie. "A PIK's value is so closely tied to a company's enterprise value cushion, something that can evaporate very quickly in volatile markets."
Phones 4U's GBP205m PIK toggle notes issued in September were bid as high as 103 in January on the back of reports the retailer is preparing an IPO, but the paper has tumbled more than ten points to just 93 after rival Carphone Warehouse confirmed that it is discussing a merger with Dixons. (Reporting by Robert Smith, Editing by Helene Durand and Julian Baker)